High-yield niche security has its own risks, rewards

By CHRIS FARRELL

Last update: August 22, 2009 - 5:00 PM

Q I am considering the purchase of a master limited partnership. Could you please address this investment in one of your articles? I would like to know what risks are associated with an investment like this.

MARY

A It's a specialty investment, a niche product. That is both its major attraction and its major risk.

Master Limited Partnerships (MLP) are limited partnerships that are publicly traded. (Of course, there are limited partnerships that aren't publicly traded, but I'll stick to MLPs bought and sold on a U.S. exchange.) A majority of the 90-some publicly traded MLPs are in the energy infrastructure business, especially pipelines. The asset class developed during the 1980s with a series of laws designed to encourage investment in energy and natural resources.

(Go to www2.standardandpoors.com/spf/pdf/index/MLP_Primer_Nov2008.pdf for a primer on MLPs.)

There are two major attractions to MLPs. They pay their owners (called unit holders) a good yield, since the bulk of earnings is passed on to the limited partners. For instance, the dividend yield on the Alerian MLP Index, a composite of the 50 most prominent energy master limited partnerships, is 8.83 percent. With an MLP, the owners are taxed only once, at the individual level. MLPs don't pay any corporate income tax. It's a financial structure that avoids the double taxation of income for corporations.

What are the risks? Like most securities, MLPs got hit hard during last year's credit crunch. A major factor behind the swoon is that these companies often have large, expensive capital projects in the works. Investors worried about their access to capital last year. The sector has since rallied along with the rest of the market. Since an MLP is a high-yielding equity security, it will lose its relative attractiveness when rates start to rise. If its business goes south, an MLP would cut its dividend.

A major complaint about MLPs is their tax complexity. It's a big reason why many investors steer clear of them. For a number of reasons it seems that MLPs are best suited for taxable accounts (and the hiring of an accountant). For example, an MLP can pass through to its unit holders depreciation of assets and expenses; that pass-through can reduce your tax hit on the investment. The tax advantage is wasted in a tax-sheltered retirement account.

There are a number of ways to own them, from buying units of individual companies to closed-end funds. The main issue with MLPs is that the security occupies a niche within a much larger universe of publicly traded securities. There's nothing wrong with that. But owning an MLP requires an understanding of both its underlying business and the distinguishing characteristics of an MLP. And I don't believe in owning any investment that you don't understand.

Chris Farrell is economics editor for American Public Media's "Marketplace Money." Send questions to cfarrell@mpr.org.

Recent Your Money stories

First-time buyer rules - August 22, 2009

First-time buyer rules - The first-time home buyer tax credit is heating up the lower end of the housing market, but homes of any price can qualify. Here are the requirements: More